Recently, I was representing a strategic buyer in an acquisition. On the surface the Letter of Intent we negotiated would, to most outsiders, not look very attractive to the seller: the buyer agreed to a down payment of less than 20%, and the seller note would have no payments during the first year. Yet, the sector the business was in was becoming less relevant and was in a state of decline. The seller's business had experienced an erosion of both sales and margins, had excessive aged inventory, and was not much above break even despite the fact that they were paying real estate rents that were a little below market. To make the business more viable would require not only a new strategy, but also a significant additional investment of capital, time, and energy. In light of the condition of the industry and business our offer was very reasonable.
When we negotiated the deal the seller did not have representation. After we got past due diligence and my buyer client's attorney submitted the binding purchase agreement, the seller brought in its attorney. The sellers then backed out of the deal. I'm pretty certain that the attorney, not understanding how precarious the seller's business was, advised the seller of the great risk associated with carrying such a large seller note. Unfortunately, I was not able to re-persuade them that given the risk factors associated with their business, the price and terms were very reasonable. This was unfortunate because unless the seller significantly turned their business around their odds of selling it would be exceptionally low, and if they were able to find a buyer for it the terms would likely be similar to, or worse than, my buyer client's offer. My buyer was willing to do the deal because of strategic implications, whereas a financial buyer likely wouldn't complete an acquisition at any price.
One of the problems that I sometimes encounter with sellers and their advisors (particularly with under-performing businesses) is that they are so concerned about the risk of a seller note default or of manipulation of an earn-out that they forget that they also have significant risks associated with not completing a deal. Following are some of those risk factors:
- The seller won't be able to find another buyer for the business in the future.
- If the seller does find another buyer who is interested, will that buyer pay a higher price or better terms than the current buyer?
- Will a future buyer be as financially strong as the current buyer and/or have the vision and management skills to improve the business and make it more profitable?
- Will the seller be able to find a buyer without hiring a broker and paying a commission? In my recent situation the buyer was engaging me, and the seller was not paying a commission.
- Will the seller be able to find a competent business broker or investment banker that will take them on as a client? For the business I described, I wouldn't have taken the business on as a sell-side client because the odds of success would have been too low for me, and I suspect other business brokers and investment bankers would feel the same way.
- If the seller does find a motivated buyer, will the buyer complete the deal after conducting formal due diligence? In this case my buyer client had made it through due diligence and was still willing to do the deal, but it's not uncommon for a buyer to terminate a deal after completing due diligence.
- The business will continue to decline. If it starts losing money, not only will the owner have to financially feed the business but marketability will be further eroded and the exit option may be to simply shut the business down.
- If the decision is made to liquidate the business, the seller may be surprised at how little he may get for the business' assets and inventory when not part of a going concern.
Not only should the seller in my deal have carefully considered these risk factors, but they also should have thought about the risk/reward relationship for the buyer. By thinking about the deal in terms of the time and money required for a buyer to improve the business' performance and what type of realistic return that would produce, it would be easy to discern that a more seller-favorable deal structure than we had agreed to would quickly become highly unattractive for a rational buyer.
If you are a seller, and your attorney or advisors tell you that a deal is bad because of the risk of non-performance by the buyer on a note, before you back out of the deal, I'd encourage you to consider the risks of not completing the deal, and whether the alternate risk/reward relationship you are proposing would likely be agreeable to any rational buyer.